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harshad mehta scam

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the harshad mehta security scam

the harshad mehta security scam

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  • 1. OVERVIEW OF THE SCAM This scam can be categorized as a Capital Market scam in which it is done by manipulating the facts in order to attain enormous profits. The “Securities Scam” refers to a diversion of funds to the tune of Rs. 4,000 crores from the banking system to various stockbrokers in a series of transactions (primarily in Government securities) during the period April 1991 to May 1992. Harshad Mehta was an Indian Stockbroker and is alleged to have engineered the rise in the BSE stock exchange in the year 1992. Exploiting several loopholes in the banking system, Harshad Mehta and his associates siphoned off funds from inter bank transactions and bought shares heavily at a premium across many segments, triggering a rise in the Sensex.
  • 2. ASPECTS OF THE SCAM  DIVERSION OF FUNDS Diversion of funds from the banking system to brokers for financing their operations in the stock market.  INTRA-DAY TRADING The modus operandi mainly included investing heavily in certain shares at the start of the day which led to a sharp increase in the price of the stock and then cashing in at the end of the day to reap huge benefits.  READY FORWARD (RF) Ready forward is actually a sort of a short term loan (typically 15 days or less) usually from one bank to another. Unlike other loans, it is actually a secured loan with Government securities backing it up . In essence, it’s like one bank selling its securities to another with a promise of buying it back at a pre-determined price.
  • 3. In early 1990s, Banks in India had to maintain a fixed ratio of their deposits in the form of Government securities/bonds which was governed by the statutory liquidity ratio (SLR). This obligation on the part of the banks required them to show a detailed sheet of its stock of Government bonds at the end of every day. Soon after the rule changed and the banks were not required to show these details at end of everyday rather they were allowed to show in once in a week i.e. Friday. This allowed the banks to sell their bonds in the earlier part of their week and then buy it back in the later part. This helped them make some profits as they could invest the money that they got by selling the bonds. The whole process of buying and selling the bonds was taken care of by brokers and only they knew the two parties which were involved. Individual banks did not have any idea as to who the other party in the whole transaction was.
  • 4. THE MECHANICS OF THE SCAM  As explained above, a ready forward deal is, in substance, a secured loan from one bank to another. To make the scam possible, the RF had to undergo a complete change. In other words it practically had to become an unsecured loan to a broker.  This was wonderfully engineered by the Brokers. To give a better understanding of the mechanism, the whole process has been segregated into three different parts viz. – The settlement process. – Payment Cheques. – Dispensing the security.
  • 5. THE SETTLEMENT PROCESS  The normal settlement process in government securities is that the transacting banks make payments and deliver the securities directly to each other.  During the scam, however, the banks or at least some banks adopted an alternative settlement process which was similar to the process used for settling transactions in the stock market.  In this settlement process, deliveries of securities and payments are made through the broker. That is, the seller hands over the securities to the broker who passes them on to the buyer, while the buyer gives the cheque to the broker who then makes the payment to the seller.  In this settlement process, the buyer and the seller may not even know whom they have traded with, both being known only to the broker.
  • 6. PAYMENT CHEQUES  The brokers asked the banks to give the cheques in their own name claiming that they will pay to the other party on their own. The practice thus emerged was that the broker would obtain a cheque drawn on the RBI favouring not himself but his bank and the bank would get the money and transfer it to the broker account on the same day. This helped the brokers to get the money as soon as the transaction is made which could further be used to be channelled into the stock market.
  • 7. DISPENSING THE SECURITY  Here the brokers used their credibility to persuade the banks to part with the cheques without actually receiving the securities with the promise that they will get the securities the next day with a 15%interest for one day. Bank officials were bribed to accomplish this task as this was illegal on the part of the banks to let go of their money without any assurance. This was Harshad Mehta and his associates were able to use the money of the banks which was eventually used for speculating in the stock market.  The brokers thus found a way of getting hold of the cheques as they went from one bank to another and crediting the amounts to their accounts. This effectively transformed an RF into a loan to a broker rather than to a bank.
  • 8. BANK RECEIPT Another instrument used in this scam was the bank receipt (BR). In an RF deal, securities were not moved back and forth in actuality. Instead, the borrower, who is the seller of securities, gave the buyer of the securities a BR. In practice, borrowing bank gives a Bank Receipt (BR) instead of delivering the actual securities tothe lender. Bank receipts serve three functions- • it confirms the sale of securities. • promises to deliver the securities to the buyer. It states that the securities are held by the sellerin trust for the buyer. • acts as a receipt for the received money by the selling bank
  • 9. • A BR means that the issuer holds the securities in trust for the buyer, but there is a possibility that the issuer may not have the securities at all. Following are the reasons for a bank to issue a BR which is not backed by actual securities- • A bank may also short sell securities, i.e. bank will sell securities it doesn’t have. This will be done if the bank anticipates fall in prices. Bank buys securities at lower prices when they fall in value and discharges the BR. • Bank may do an RF deal and issue a fake BR (not backed by securities) if banks simply want an unsecured loan , where a lending bank would be under the impression that it’s dealing with a secured loan but in reality it’s advancing an unsecured loan. Though, lenders should have taken measures to protect themselves .
  • 10. During the scam, brokers were so perfect in the art of using fake BRs and obtained unsecured loans from various banks. They managed to persuade little known banks like the Bank of Kanad (BOK)and the metropolitan Cooperative Bank (MCB) to issue BRs and then these BRs were used to do RF deals with other banks. This way several large banks made huge unsecured loans to these banks and thus it created money for the brokers.
  • 11. CONTROL SYSTEMS There was a complete breakdown of the control system within the commercial banks and that of RBI. Following features are involved in the internal control system:  Whenever an RF deal is done by using BRs rather than actual securities, the lending bank has to contend with the possibility that it may be making an unsecured loan. This requires assigning credit limit to the borrower by assessing the creditworthiness of the borrower.  The different aspects of securities transactions of a bank are carried out by different persons.
  • 12. Some of the stocks which were highly invested in by Harshad Mehta were-  ACC  Apollo Tyres  Reliance  Tata Iron and Steel Co. (TISCO)  BPL  Videocon The following graph shows the rise in the Sensex during the period when Harshad Mehta was operational and putting in loads of money in the stock exchange increasing the liquidity and thus arbitrary increase in the prices of some shares.